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KGB: ANZ's Liu Li-Gang

ANZ Bank's chief Greater China economist says Beijing may be behind the curve on economic stimulus, while ambitions to internationalise the renminbi are very real and could see the unit traded directly with the Australian dollar in the near future.

Alan Kohler: So Li-Gang, we saw Chinese inflation come down quite a lot this week from 3 to 2.2 per cent. Is this good news or bad news do you think?

Liu Li-Gang: It is both good and bad news. The bad news is that this indicates that the output gap in the economy may be larger than we expect. This also suggests that second quarter GDP growth could be slower than expected. And the good news is that, you know, with falling food prices Chinese consumers will have more money to consume other goods. To some extent it will stimulate consumption in other areas.

AK: And also of course it provides the government with more room perhaps to stimulate the economy if that is required. Do you think the government will do that?

LL: Indeed that’s widely expected. In fact, if you look at the People's Bank of China's interest rate cut last Thursday, basically it frontloaded this CPI news on Monday with lower inflation and the PBOC will be more willing to use monetary policy to stimulate the economy. We still expect that three more reserve requirement to ratio cuts of 50 basis points each will be possible in the remainder of the year and with such large monetary and the fiscal stimulus we do expect that the Chinese economy can have a cyclical upturn in the second half.

SB: Li-Gang, have you been surprised by how marked the deceleration in the Chinese economy has been this year. Do you think the authorities were taken aback by how rapidly it slowed?

LL: Well, we are a bit surprised. A bit, you know. We are a bit surprised by the slowdown and to some extent there are both policy factors and other structural issues we do not understand. On the policy side we think that, you know, the Chinese policymakers may be too cautious in stimulating the economy. For example, they have been very slow in using monetary policy to stimulate the economy and they are quite reluctant to use reserve requirement ratio cuts and interest rate cuts. And when they uses it, it was a bit too late in the cycle. We know that monetary policy has to be forward looking and you cannot use it to react to a slowdown.

And I would say that to some extent the PBOC may be behind the curve in engineering you know, a cyclical upturn in the Chinese economy. On the fiscal policy side if you look at the Chinese fiscal policy implementation in the first half, to some extent we don’t know, for some reason we don’t know, they have been quite slow in implementing their fiscal budgets this year. For example, the central government has a rather ambitious public housing program and they want to build the seven million public housing units this year. And in the first four months of the year they only dispersed 17 per cent of the total 400 billion renminbi to be used to build public housing units.

You know, if the central government does not want to put its money into building and the public housing program, it’s very difficult to ask the local government to put the matching funds to build the, you know, the public housing units. As a result we have a slow construction sector that has slowed many upstream, middle stream and downstream industries in China. As a result we see this slower than expected economic growth. The final factor I would like to mention is that, you know, maybe there are some structural changes in the economy. We don’t know, for example, if the harsh property control policy has been a drag to the economy and perhaps the government and also the economists have underestimated the impact of a slowdown in the construction sector on the Chinese economy.

Stephen Bartholomeusz: I wantedto ask you about that – that crackdown on property. How much of the slowdown relates to external issues – you know, the problems in the eurozone and slow growth in the US – and how much to that decision last year to clamp down on the property bubble?

LL: I would say that the decision to clamp down on the property bubble is having a larger impact on the economy than the external slowdown. And in fact, if you look at China’s exports so far this year, on average it’s leading the expectations and, you know, around 10 per cent so far. And we more or less understand that Europe will be quite weak and Chinese exports to the rest of the region will not be very strong, because of the rising renminbi value and also rising production and wage costs in China. And perhaps that type of trade channel has already been priced in, but what cannot be priced in is the confidence channel. And in the first half of the year the euro debt crisis has made many Chinese exporters very much worried. As a result they will be very much reluctant to engage in further investment in the sector.

AK: So, what does that imply for the project of rebalancing the Chinese economy away from exports and towards domestic consumption?

LL: Well, I think this rebalancing effort is still on track and this has been the government’s goal set out in China’s 12th five year plan. In this medium term economic plan and China has mentioned that it would like to rebalance its economy from relying too much on external demand and the investment to more consumption led economic growth. I don’t think this overall medium term goal has changed much. The weak external demand will help accelerate this type of rebalancing but we have to recognise that in the short term, you know, it’s very difficult for the government to stimulate the consumption because the consumption is an individual household decision and the government policy can only help pull consumption to grow, but it cannot push consumption to grow. What the government can do is to provide the favourable conditions for consumption to grow. That is, the government would have to spend more on social welfare by setting up a medical care program and a pension system and also by reducing China’s very expensive education system.

SB: Li-Gang, a moment ago you referred to the export performance. It's surprised people, I suppose, that it has held up as well as it has, but the most recent numbers though show a significant underperformance in terms of a lot of snipping and reduction in imports. How do we interpret that? Is that a lead indicator for a further softening?

LL: Well, the slowdown in exports was led by both price effects and also domestic weak demand and the price effect actually would be favourable.

AK: Do you mean imports or exports?

LL: The imports. The import prices because China imports a lot of commodities and this year we have seen a sharp drop in commodity prices and in that sense in value terms we tend to see a decline in imports in value, but in volume terms it perhaps has not changed much. For example, in China’s first half of the year iron ore imports, in volume terms, actually it’s increased by 9.7 per cent, but by value terms it actually declined a bit. And so I think this is one factor that is affecting China’s slow imports. I think the other part I think is more worrisome is that if you look at China’s import structure other than so called ordinary imports in the form of iron ore and the final consumption goods, we also have this intermediary imports and this means that, you know, China would have to import a lot of such intermediary goods using its inexpensive labour to assemble and then re-export the final product to the third market and if this component remains weak, that means in the coming months, you know, in the coming months the Chinese exports that will remain weak. Indeed, weak imports do not bode well for a strong export growth in the coming months.

AK: We’ve been talking a bit about cycles, Li-Gang.

LL: Yeah.

AK: You know, the cycle over the first half of the year was surprisingly soft. You’re saying that the cycle will move up perhaps in the second half of the year, but do you think that stepping back from that towards a more structural view, China’s long-term growth rate now must structurally be lower than it has been perhaps over the previous five years?

LL: That’s for sure because as China’s per capita income has grown a lot. You know, at the end of last year on average it was $US5000, but in some coastal regions the per capita income has already reached to $US10,000. So, you can see that Chinese growth is bound to slow. The coast region will tend to slow much more than China’s central and the western region. But overall we think that although there’s this structural factor that will slow down the Chinese growth in the next five years. We still think that a growth rate around 6 to 7 per cent can still be obtained, largely because on average Chinese per capita income is still low and also one important factor on the capital stock side that is we economists tend to use capital stock per person to measure whether a country still has room to invest.

China’s capital stock per person is around $US10,000 where the same number in Australia, in the United States, in Japan could be more than $US100,000 per person. So, you can see that indeed despite China has experienced the very rapid investment growth in the last 30 years because it started from a very low base, so it still has a lot of room to catch up. That’s why we think that going forward China’s urbanisation will be the major driver for further economic growth. This also means that Chinese investment, although will slow down over the next five to ten years and the growth, the pace of growth, will still be quite substantial and we will not see a sharp slowdown in the investment side. So, I don’t think we need to worry that Chinese demand for commodities will suddenly disappear.

SB: Li-Gang, if you’re right and that China is going to grow at 6 or 7 per cent in future rather than the sort of very high single and even double digit growth rates of recent years, there’s a view outside China that the Chinese authorities believe that 8 per cent GDP growth is the minimum level to manage the migration of the people from the rural areas to urban areas and that without that sort of growth level you would get social unrest. Can you reconcile that sort of outlook for a lower than 8 per cent growth rate with the political imperatives?

LL: Yeah. The 8 per cent growth could be a benchmark over the last, you know, five to 10 years, but China has been experiencing a very rapid demographic change and, you know, by 2015 the working age population will start to decline and we have already seen that in China’s coastal region it is difficult to find skilled workers and also reading the migrant population we have seen some structural changes. Certain young people they don’t want to work in, you know, assembly, manufacturing firms engaging those repetitive types of work. They want to work in some service sector. And so all these factors, you know, are suggesting that, you know, labour shortage may no longer, you know, labour surplus may no longer be a big issue in China.

And I think with 6 to 7 per cent growth in the next five to ten years, I think it is still high enough to coverfor the potential migration. And finally I would like to mention that the reason we have seen a lot of migration from China’s central and the western region to coastal regions is that in the past there were not many work opportunities in China’s central and the western region, but with very rapid infrastructure buildup. A lot of labour intensive firms have started to move to China’s central and the western region. For example,one of the largest Taiwanese OEM producers has established the several large plants in China’s central and the western region.

So, as a result that we have seen more job opportunities in China’s central and the western region, so the pace of migration from China’s inland to coastal regions has also declined. So, that’s why I think that a 6 to 7 per cent growth will be sufficient to absorb migration and if we can maintain such a pace of growth, this will be a quite good growth record. That means by almost 10 years later the Chinese economy could be almost as large as the US economy and by that time I think China will experience a lot of labour shortage problems.

SB:Last thing, Li-Gang. The Australian Treasurer Wayne Swan is heading to Beijing to talk to the Chinese authorities about direct convertibility of the currencies. China has been doing a number of those deals recently and it’s allowing more centres to trade RMBs, expanded the trading band and it’s even starting to open up its capital account. Is it a realistic ambition for China to internationalise the yen and become one of the reserve currencies?

LL: Well, I think this ambition is very real and whether China can internationalise its currency will depend on whether China can open its capital account eventually, during the process whether it can make its domestic financial system competitive so that they can manage risk well so that, you know, large capital inflow and outflow from China will not affect the Chinese domesticinterest rate much. And also the exchange rate volatility will be, you know, managed well. And so, I think there are a lot of challenges going forward, but without opening the capital account it also offers a lot of opportunities for the renminbi to be first used as a trade invoicing currency.

We think that going forward there are a lot of new directions in China for renminbi internationalisation. For example, we have seen that for the first time the Japanese yen and the renminbi can be traded in Shanghai and the Tokyo markets and that means we will have a convertibility between the Japanese yen and the renminbi. So, in the future exporters importers in both countries will be able to use their own currency to conduct trade with each other without going through the US dollar.

In the not so distant future we can see the Australian dollar and the renminbi can be traded directly in the Shanghai market for example. This means that the renminbi could be used as a trade invoicing currency for Australian and China trade. We do see there is great potential in this area. For example, a mining firm in Australia could receive the renminbi for its iron ore export payments. Some of the renminbi payments the miner receives can then be sold to an Australian imports importer who conducts trade with China and then the remaining amount using this Australian renminbi dollar direct trade could then be swapped back to Australia. In this type of transaction only two currencies are used.

As a result that the importers and the exporters tend to gain from this process because they don’t have to change their currency to the US dollar. As a result the transaction cost and hedging cost will be reduced. So, indeed I think going forward we do see this is a new direction in China’s renminbi internationalisation. And if all this were to happen, that means the Hong Kong renminbi bond market will become also quite large and I would suggest that, you know, some Australian firms, especially the mid-cap mining corporations, could look into the Hong Kong renminbi bond market as a potential funding source. This market has become bigger, more liquid and it could be an alternative funding source for Australian firms with a China market focus.

Finally, by tapping into this market Australian firms could diversify their funding source reducing funding costs and mitigate the risk of currency mismatches. So, all these advantages suggest that indeed going forward the renminbi will not only become a trade invoicing currency, but also a potential funding currency for Australian mining investment.

SB: Li-Gang, we’ve taken up a lot of your time. I very much appreciate your making yourself available and providing us with your thoughts, so thank you again.

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